Paying Down Debt: Lowest Balance or Highest Interest Rate First?

by Kevin on July 20, 2011

There are two contrasting views of paying off your debt load: to pay the lowest balance first or to pay the highest interest rate debt first. Let’s dissect these two schools of thought and see which is better for your situation.

To start, we need a debt scenario. Let’s take Average American Joe (AAJ). Here is AAJ’s situation:

His family makes $50,000 per year.

They spend less than they earn, and after paying the minimums on their debt they have free cash flow of $5,000 per year ($416 per month).

They have one car loan with a $400 payment. The interest rate is 4.9%, and the balance is $10,000.

AAJ has student loan debt balance of $25,000 with an interest rate of 6.8%. The payment is $195.

The couple financed their lifestyle for the last few years, and have $30,000 in credit card debt at a whopping 17% interest. The minimum payment is $600.

In short, AAJ has $416 per month to apply toward paying down his debts. His combined minimum payments are $1,195. His total debt is $65,000.

Which path should AAJ take? Should he go after the lowest balance first (his car loans)? Or should he target that big interest rate on the credit card first?

Pay Off Lowest Balance Debt First

Many people prefer the lowest balance method because it helps you build momentum. You knock out that first debt as quickly as possible and get a “quick win” that makes you feel good about your progress and fuels your motivation toward the next goal.

If AAJ decided to pay off his debts in order of lowest balance first, he would target them in this order:

Car loans – $10,000

Student loans – $25,000

Credit card – $30,000

If he applies his $416 toward the car loan first, he will pay it off in 13 months. He then applies the car payment along with his extra $416 toward the student loans, and pays them off in an additional 26 months. He repeats the process and wipes out the credit card in another 15 months (in the 54th month after he started paying off his debt).

In this situation, AAJ pays a total of $20,573.19 in interest. As you can see, he wipes out the car loans in just over a year and gets his big win. The psychological momentum can be a tremendous boost because you are seeing real results fairly quickly.

Pay Off Highest Interest Rate First

While the lowest balance method helps motivate you to continue, it ends up costing you money. If you target your highest interest rate debt first, you save money because you are knocking down your balance, and thus your interest charged, on the most expensive debt. Maintaining momentum may not be as easy, especially if the balance on the high debt (usually a credit card) is very high. It seems like an eternity that you are fighting against the debt, and it can be easier to lose motivation.

If AAJ decided to pay off his debts in order of highest interest rate first, he would target them in this order:

Credit card – 17%

Student loans – 6.8%

Car loans – 4.9%

If he applies his $416 to the credit card (and stops adding to the balance by cutting up the credit card), he will pay it off in 35 months. (That’s an extra 22 months before paying off the first debt as compared to the lowest balance plan. See how it can be easy to lose motivation?) If he then rolls the $600 minimum payment he has been making with his $416, he pays off the student loans in an additional 15 months. In this scenario the car payment doesn’t even come into the equation because by the time the first two debts are paid, the car loan has been paid off with the regular payments. He is debt free in 50 months, 4 months ahead of the lowest balance first plan.

In this situation, AAJ pays a total of $15,199.32 in interest. That is a reduction of $5,373.87 or 26%. I don’t know about you, but saving over $5,000 just by finding some internal motivation to pay off the highest interest rate debt first seems to make a lot of sense. I could use $5,000+, couldn’t you?

Every Situation is Different

Your personal situation might be different than our example. Maybe your debts are really close together in terms of balance and interest rate. Maybe you don’t have a lot of internal motivation to pay off the debt.

Do what works for you. But be sure to run the math behind what will get you out of debt the fastest. Whatever you decide, remember that even if you ended up paying more in interest… you’re still paying off debt. You’re still working a plan. And that’s what matters most.

i have 3 credit cards, all at 0%, but which 1 should i pay off first, 15 mons. to pay off $4000. 13 mons. to pay off $7000. or 9 mons. to pay off $11,000. Shouldn’t i pay off the 1 with the shortest amount of mons. The longer mons. gives me a little more breathing room. The 11000. will go to 9.99% after 9 mons. Thanks

There is your answer: the 11000 one will start costing you a high interest rate 9 months from now. So the more you pay that one off now, the less interest you’ll have to pay for it 9 months from now. (If you can pay off ALL of it before that time, you have saved yourself a lot of interest). And so to understand it correctly: the other 2 credit cards will stay at 0% ???

Another great article, Kevin. When my husband and I got married, we both had student loans. Our loans were not tax deductible (from a private Christian University). Our rates were different, so we chose to pay off the one with the highest interest first while paying the minimum on the second loan. This process worked beautifully for us. Just watching the balance amount decrease each month was enough motivation for us.

We evaluated our situation, set a goal, made a plan, and executed that plan until we reached our goal. Had there been hiccups in the road, we would have re-evaluated our situation, kept our goal, readjusted our plan, and then executed our revised plan.

If you’re in debt, keep reading here. Kevin has great articles, like this one, to help you work through this process. Even if you can only add $5 to your debt each month, you will be working toward your goal. Keep making progress no matter how small it is.

If you need encouragement along the way, set a goal to pay off $100. When you reach it, celebrate with a favorite dessert or other inexpensive indulgence you enjoy. Happy savings!

If you need motivation, you could look at the total amount owed, you will see that go down each month. And also you can calculate how much money you’ll save by using the “highest interest first” option and keep a reminder of that amount (and the number of months left before you have paid off fully) somewhere.

A good reason to pay off the loan with smallest balance first would be if your income changes month to month or you fear that your income will decrease in the near future. Getting rid of one minimum payment may then help you in meeting all your financial requirements in a month when income is low.

There is a 3rd way to choose the bill to be paid off – choose the bill that will be paid off the soonest.

The easiest way to figure that is to divide your current balance by your current monthly payment. The bill with the smallest number gets paid off first.

I think that method provides the best balance between choosing highest interest or smallest balance. If two bills have similar balances, the bill with the higher interest rate will be chosen. If two bills have similar interest rates, the bill with the lower balance will be chosen.

I’ve been plugging away at my debt for some time now, being a single dad it’s not always easy to just stick to my budget. That’s my own issue though. I’ve looked at using the snowball and avalanche systems. I tend to pay off the small balances that have 0% interest for a short period of time, to avoid any interest on them at all. May not be the best in the long run, but then again, I revisit my plan every couple months to see where I’m at.

As for AAJ in the example above. These scenarios always seem to be aimed at over dramatizing the amount of interest you save. Let me try to break down what I’m getting at.

There are 2 plans the lowest balance first and the highest interest first . I assume that AAJ incurs no additional debt and he doesn’t get a raise in the 4 years he’s paying down his debt. Also, his family must be living in a hovel to be blowing 1200 a month on debt (of $50,000 / year that’s easily one paycheck or more per month) let alone being able to throw another $416 on top. Tongue in cheek, I know it’s just an example and is meant to be extreme …

So, we have AAJ paying $1611 ($1195 + $16) per month to his debt for either 54 or 50 months. Yay for AAJ saving $5000 in interest, but he does not have $5000 at the end of 50 months,by paying off the highest interest first, at least not anymore than he would at the end of month 50 if he were paying off the lowest balance first. No new money has come in at the end of month 50!!

HOWEVER!! This is the part I like about paying off the highest interest rate first. As long as AAj doesn’t go on a wild spending spree in months 51 – 54, and he puts the total monthly payment into savings, he will have $6444 at the end of month 54!!! Now that’s what people fail to tell you!! I could really care less about how much I save in interest. As long as I’m paying the same amount for 4 years that doesn’t matter. The point is to get your butt out of debt and for you to figure out what works best for you, today or this month. Seeing those $$$$’s in your savings account in the future is great, but stay grounded and keep chugging away.

One more thing. When you get a raise, use that extra money per paycheck to increase the amount your paying down every month, the end will come much faster!!

I have 2 car loans, both with the same exact interest rate but 2 different companies. One of the cars cost 3K more than the other and therefore the monthly payment is about $30 extra each month than the other car. Which car should I pay off first?

I would re-sort by interest rate, and then pay off the debts from the highest interest rate to the lowest. If two debts have the same interest rate, then I would pay off the largest balance first. This is just my two-cents. Good luck!

I always feel as if these debt scenarios are for people who used credit wrong and now is screwed… but what about people who was just broke, and now has some money to take care of the delinquencies they have created.

I paid cash for everything I own.. and when I did have a credit card I used it correctly. but not having insurance and not being able to pay medical bills, and not being able to pay all of your college loans back, for a while interest leaves the picture.

I make $2,500 p/month, my monthly expenses are roughly $1,200 and I only have $7k in debt… no credit cards and no auto loans… just student loans ($4k in charge-offs) and Medical bills ($3k). So interest doesn’t’ play a part in my equation, so which should I use?

Its best to pay the smallest balanced loans first and as you pay them off move to the next smallest loan. I broke my own advise because I am working on paying off a $87,000 student loan @ 7.875% interest. I have 3 more payments but have been paying on this loan for 10 years. Once its paid for I have $1000 extra per month so it was worth the sacrifice. I do not try to pay off my car early because the interest is only 2.7%. I am working on paying off my house in 6 more years. I have credit card payments but they are usually paid monthly of within a couple of months. The best advise is, do not get into debt. Student loans are good debt but try to work part-time through school.

I was wondering if someone could help me figure out what would be the smartest course of action, that will save me the most money in the long run.

my school loan is divided into smaller loans with different amounts and different interest rates. just say I owe 5,000 at 6.25% and 60,000 at 4.5%. I’ve been paying down the one with the lower interest rate because it has a way higher balance than the other one… but someone told me I should still be focusing on paying down the higher interest rate.

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I have a loan of $8000.00 interest 7%
$2500.00 0% for 2 years
$800.00 0% for 1 year
$2500.00 5%
plus my car payments, but I am more concerned about getting rid of these credit cards before I pay off the car payments. So out of the above, which should I pay off first if I am paying $1000.00 a month. We are paying $1000.00 so we can get out of debt faster before making anymore purchases.